Not everyone feels smart when it comes to understanding the meaning of a home loan comparison rate. Many Australian borrowers either don’t know what it means, or they mistakenly believe it provides a comparison of the lender’s best rate.
Ironically, comparison rates were introduced to clear up confusion and give consumers an insight into the true cost of a home loan. Displayed as a percentage, a comparison rate includes the home loan’s interest rate together with fees and charges that may apply to the loan.
Their purpose is to help protect borrowers from taking out loans that appear attractive due to their low interest rate, but end up costing far more. This is particularly relevant with honeymoon loans, where the low interest rate jumps up after a set period.
Since 1 July 2003, it is a legal requirement for lenders to publish a comparison rate alongside their advertised interest rate.
Unfortunately, the comparison rate formula for home loans hasn't kept up with the times. It's calculated on a loan size of $150,000, which is far below the average mortgage size in Australia of $369,600 [i]..
So while it's a helpful indicator, it doesn't tell the whole story.
How are comparison rates calculated?
Every comparison rate you see advertised is calculated using an industry-wide formula. This ensures consistency from lender to lender, allowing you to compare ‘apples to apples’.
The National Credit Code states this calculation must include the home loan’s interest rate, repayment frequency and any of the following fees that may be applicable to the loan:
It’s mandatory for the calculation to be based on a $150,000 loan over 25 years of paying principal and interest. If this isn’t reflective of your loan amount or term, you can calculate the comparison rate yourself with the help of your mortgage broker and a good comparison rate calculator.
The limitations of comparison fees can be seen if we compare two different loans.
Loan 1. - Variable Rate 4.00%
No set up or on-going fees, no discharge costs.
Loan 2. - Variable Rate 3.69%
$300 upfront fee, $398 annual fee and $295 discharge costs.
If these products are advertised, the comparison rates based on a 25 year loan term and $150,000 loan amount are 4.00% and 4.11% respectively. This suggests the loan product with the ongoing fees is more expensive.
However, if the comparison rates are calculated on a more common loan amount and term, such as $450,000 over 30 years, the outcome is quite different. While the no-fee product again comes in at 4.00%, the annual-fee product now compares more favourably, with a calculated comparison rate of 3.82% p.a..
Do comparison rates include all fees?
Don’t make the mistake of thinking that comparison rates have you covered for all home loan related fees. Extra fees you might face include redraw costs and early termination fees if you end your fixed rate home loan early. Legal charges, valuation fees and government costs like stamp duty are also not included in comparison rates.
If you’re taking out a large loan or have a small deposit, you may also have the cost of Lenders Mortgage Insurance (LMI). The comparison rate assumes the loan is for 80% or less of the property’s value, thus LMI is not applicable.
Don’t rely on comparison rates alone
While the comparison rate is a useful tool for comparing the cost of different loans, it shouldn’t be the only factor to consider when choosing a loan. Features and benefits like redraw, offset and flexible repayment periods are all important considerations when deciding if a loan suits your needs, and these need to be considered by your broker or lender when discussing the best product for you.
Your repayments will also have a part to play in the true cost of the loan. The faster you pay back your loan, the lower the cost. Interest only repayments will have the opposite effect, as comparison rate calculations use both principal and interest.
For a complete picture of the fees and charges associated with a loan, speak to your local Yellow Brick Road mortgage adviser.